Section 83 is a key part of the Internal Revenue Code (IRC) that all startup founders and employees should be familiar with. Section 83 details how stock options are taxed and how to file for the early exercise of stock options.
Understanding how Section 83 works and how to file an IRS form 83b election can mean the difference between paying a small amount of income tax on stock options (or similar equity grants) when you receive them or a huge tax bill when they vest at a higher price later on.
File now…or pay more later. So, why would you worry about income you can’t capitalize yet? Simply put, you could be saving quite a bit later on in terms of the tax on your shares. At its core, an 83b election allows you to convert your stock option gains from short term capital gains to long term capital gains.
Short term capital gains are taxed as ordinary income with a potential federal maximum of 39.6%, while long term capital gains are taxed at a rate between 0% and 20% at the time you capitalize them. Form 83b allows you to avoid taking on any tax liability—at all—for your stock options until they vest, provided that you are purchasing (or granted) them at the Fair Market Value (FMV).
Although there are technically as many types of equity grants (and equity warrants) as corporate lawyers can dream up, there are only a few typically used by most startups. Legally, equity grants are used to compensate founders and other employees, but are not intended to be used to pay or reward investors or service providers, though they sometimes are… don’t worry about this for now.
For now, what you need to know is that there are Non-Qualified Stock Options (NSOs) and Qualified Incentive Stock Options (ISOs). Startups usually issue ISOs to employees and founders as they have tax benefits and are eligible to take the 83b election. The distinction between these two types of grants is discussed further in the article ISOs vs. NSOs: Which Are Better For Employees?
You may have heard of RSUs, or Restricted Stock Units. This term covers any combination of stock options and restricted stock, and is gaining popularity recently thanks to the amount of control it offers new ventures over the exercise of their stock. We’ve outlined the key differences in taxation on restricted stock in the article Employee Stock Compensation: Equity vs. Options.
Back to Section 83b...
Section 83a establishes tax responsibilities for employees or founders. IRC Section 83b allows stock option holders to write a letter declaring their intention to take a Section 83b election to the IRS within 30 days of the original options grant. Since the value of the stock options and the fair market value are the same, there is no tax liability at this time.
Tax Consequences of Taking the 83(b) Election
Consider an employee who has been granted options for 10,000 shares of stock, with a fair market value of $0.50 a share. The vesting schedule provides 2,500 shares at the end of each 12-month period following the grant date. Imagine the company’s stock has a fair market value of $3.00 at the end of year one, $10.00 at the end of year two, $15.00 at the end of year three and $20.00 at the end of year four.
Under IRC Section 83a, the employee would be liable for taxes totaling $34,500 after his or her stock fully vests at year four. However, if Section 83b election is taken at the date of the grant, the cost of the 10,000 shares is locked in at the fair market value, $0.50 per share, so the taxable income is only the price of the stock options at that time: $5,000, a tax liability of around $1,750 at the federal maximum rate.
The stocks are then taxed at the rate for long term gains when they vest and there is no further liability until that time.
A Section 83b election is not without risks, and while it is possible to amend a form 83b, in practice it is incredibly hard to revoke or rescind one once it is filed. It is possible (but highly unlikely) that the value of the shares may decline or the startup may fail—but the market value of early-stage startup stock is usually very low, making the Section 83b election a very low-cost choice regardless of the outcome.
Remember … You’ve Only Got 30 Days
Do not forget the 30 day period mentioned above! This is a hard and fast deadline, and once it passes you are disqualified from making a Section 83b election. In addition to filing your letter with the IRS, a copy of the section 83 b election form must be submitted to your employer. If you are married, your spouse must sign the form election as well.
The 30 day 83b election deadline begins the day of the award itself, rather than the date on which documents are received. The window includes non-business days (Saturday, Sunday, holidays) as well.
At Capbase, we’ve created a standardized form to make filing your 83b as simple as possible. Since you’re likely just beginning, know that your company’s initial stock issuance alone does not trigger the beginning of the 83b election window, it is the actual purchase of the stock.
Interestingly, this is one of the few documents that must be submitted with a “wet ink” signature—rather than a digital one. Send the 83b election form to the IRS service center where you file your taxes The IRS will respond with a stamped document to confirm the receipt.
- All founders and employees should be familiar with section 83 of the IRS tax code, which contains information on how stocks, stock options, and other equity grants are taxed.
- The 83(b) election form must be signed with “wet”/not digital ink and, if you are married, must also be signed by your spouse.
- The 83(b) election allows you to pay tax on only the current FMV at the time of purchase.
- To have them taxed as capital gains, you must hold your stock for at least 1 year after exercise.
- You must file for an 83(b) election form within 30 days of the stock purchase for the IRS to approve the election